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Impact of Capital Structure on Profitability

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Published: Mon, 18 Dec 2017

Introduction

A capital structure concerns the composition of the liability of a company or, more specifically, which is the relative participation of the several financing sources in the composition of the total obligations (Brealey and Myers, 1992; Gitman, 1997 and Weston & Brigham, 2000).

Capital structure decision is very vital for any organization; every organization wants a mix or arrangements that eventually achieves or increases its profitability and overall value. Different alternatives available to companies to finance its self sometimes through issuing shares securities, or some time from debt, organizations achieve different combinations huge or small amount of debt. An organization takes the combinations, which increase their efficiency and profitability and its market value.

These types of decisions are very difficult in an uncertain economy. Such as; In Pakistani scenario existence of the macro environment factors such as lofty interest rates in double figures and volatility in economy and in political situations are big factors for the combination of capital structure. Consequently, the financing decisions experienced a significant rise of costs, in addition the diminution of the economic activity, which also raise the uncertainty.

However, many theories and practical approaches contributed on capital structure, which ultimately give abundant literature:

Target Capital Struture

For the establishment of a target capital structure, the firm should analyze certain factors such as; mix of debt, preferred stock and common equity. The specific capital structure may be changed accordingly to conditions. The change in capital structure occurs due to the debt ratio. If the debt ratio is below the target level, the debt should be issued to raise the capital. If the conditions are in reverse, visa versa; the debt ratio is above the target the expansion capital should be raised by issuing equity.

The firm, in its structure policy, involves a balance between risk and return in order to achieve the best combination to maximize the firm’s value. There are four primary factors, which influence capital structure decisions, they are:

  • Business risk
  • The firm’s tax position
  • Financial flexibility
  • Managerial conservatism or aggressiveness

The above four factors largely determine the target capital structure. If no debt is used in the firm’s operations, it is at greater business risk while its favourable debt ratio is lower. If the firm uses the debt, the interest is deducted and the effective cost of the debt is lowered that is the major reason for using debt in the firm’s capital structure policy. If the firm’s income is sheltered from certain taxes such as; depreciation tax shields, interest on currently outstanding debt, tax loss carry-forwards. In such conditions, the firm’s tax rate will be low and in that condition additional debt will not be as advantageous as with a higher effective tax rate.

If the conditions are adverse the firm should raise the capital on reasonable terms as steady supply of the capital is necessary for long run success it is in the knowledge of treasurer that at the time of tight economy or operating difficulties the suppliers of capital provide the funds with strong financial statements. It has, therefore observed that need for funds and the results of the fund shorted influence the capital structure. Hence, if the future need for capital is greater the consequences of capital shorted become worse. Therefore the financial statements should be stronger.

The managerial conservatism or aggressiveness also influences the capital structure, managers of different firms possess different nature and observations or approaches some are aggressive than others and some are inclined to use the debt to get more profits. Though this factor is in effective to the favorable is value maximizing capital structure, yet it has great influence on the managerial target capital structure.

On the whole the target capital structure is much influenced by the above four factors, due to which operational conditions can cause the actual capital structure to vary from the target capital structure.

Optimal Capital Struture

Most favorable capital is a capital which maximizes the worth of the company’s stock it is also with a minimum weighted-average cost of capital generally known WACC. It does not necessary increases or maximizes earnings per share (EPS). Maximum earning per share (EPS) is not always achieved by attainment of the greater stock prices. With higher debt ratio may result in maximum earning per share (EPS), but may also increases firm’s risk level. Some debt employed by in optimal capital structure, but does not hundred percent (100%) debt employed. Some firms try to achieve different combinations of optimal capital structure; but they could not achieve this optimal capital structure or optimal point. There are many ways of the estimation of required rate of return on equity capital (RROE); through accumulating company’s long-term cost of debt.

Theories Of Capital Structure

It has been observed that the capital structure of different industries vary form each other it is due to different reasons. If we observe two different companies from two different companies such as; pharmaceutical companies and airline companies the capital structure of the both companies quite different from each other. The reasons of the different capital structure of the different firms and industries are given in the theories, which are subjected to empirical tests.

Modern capital structure theories are based on the published articles of professors’ Fransco Modigliani and Marton Miller (1958), generally known as (MM). According to MM the firms value is not affected by its capital structure and they further contributed were that the capital structure is irrelevant to a firms operations hence; MM has presented some unrealistic assumptions such:

  • There are no brokerage costs
  • There are no taxes
  • There are no bankruptcy costs
  • Investors can borrow at the same rate as corporations
  • All the investors have the same information as management about the firm’s future investment opportunities
  • EBIT in not affected by the use of debt

Though some of the above assumptions are quite unrealistic yet; they are important as they indicate the conditions under which capital structure is irrelevant. MM have not only given unrealistic assumptions but they have also provided different clues, which show the required relevant capital structure and also affect a firms value. Thus MM assumptions gave the way to modern capital structure research and helped to develop more realistic theories of capital structure.

The Trade-Off Theory

The trade-off theory is very important theory; because it deals with the finance and equity. Which ultimately, elucidate how firms finance their venture for a time by equity and debt, theory also discuss the pros and cons of both ways. Companies’ best possible leverage change is inclined by firm’s adjustment toward an optimal leverage is inclined by three features such as: taxes, costs of financial distress and agency costs.

Taxes And Bankruptcy Costs

Tax rate and leverage are positively related; markup is a tax deductible, it reduces tax liability and enhances the after tax cash flows being a tax subtracts expense. Companies’ get on elevate point of debt if the tax charge is higher because Firms wants in their endeavor to enlarge cash flows and market value.

Taxes

Chance of defaulting enhances when the level of debt away from best possible point. When firm failure to pay loan than power of the firm will be transferred from shareholders to bondholders who will strive to recover their venture throughout the practice of bankruptcy. With financial distress company may incur two natures of bankruptcy costs. Direct and indirect costs direct cost comprise of administrative costs of bankruptcy practice. These costs will be lower proportion of the total cost when the firm size is large and vice versa with small size firm and may important variable in choosing the level of the debt. When investment policies of the company change which results in occurring of indirect costs. Firm can reduce the chance of bankruptcy with cutting down expenses on training, advertisement, research, and development etc. It also increases the customers’ reservations about company’s offerings, which result in lower sales, market share, customer loyalty, and market share price etc. This entails that the prospective benefits from utilizing leverage are outlined by the latent costs of bankruptcy.

Miller And Modigliani Theory

Modigliani and Miller (1958) give you an idea about that the value of the firm does not change when any change occur in the capital structure. Firms build total cash flows for all investors are unchanged despite the consequences of capital structure. Altering the capital structure does not amend the total cash flows. Consequently the overall assets’ value provides ownership of these cash flows should not change. MM argue if worth of the firm depends on capital structure; which may be result in arbitrage opportunity in the perfect capital market. In addition, capital structure decision may be counteract when investors and firm can have access to at same rate. Despite the fact that MM theory is stands on numerous impractical assumptions, yet it presents the essentials theoretical background for further research.

Agency Theory

Jensen and Meckling (1976) discuss about the potential disagreement or relationship between company’s executives and shareholders, according to theory managers do not have 100% interests in firm. Executives are the representatives of the shareholders and strive to assets away from bondholders to shareholders through captivating more loans and empowering in risky assets.

Information Costs And Signaling Effects

Capital structure can also be elucidate when disparity in information have available to stockholders and stranger regarding the investment opportunities and income allocation of the firm. This information parity may consequence in two separate results for capital structure, it is known as signaling with percentage of debt.

Ross (1977) contributed that manager always familiar about the financial position of the company and its return allocation. When executives take debt decisions, it produce affirmative signal to stakeholders; about the financial position of the organizations and its ability to retire its debts and truthful allocation of return of the company. Managers always try to increase stakeholders or investors confidence, consequently with increasing equity value as result in also using significance amount in the capital structure.

Pecking Order Theory

Myers and Majluf (1984) state that shareholders always think executives employ confidential information when they offer risky securities and also overpriced. This observation guides under pricing of fresh equity offerings, this also may result in significance loss of present shareholders. For these reason organizations keep away from offering new projects through equity financing and use its internal funds if further financing is required they issue debt last option is equity financing.

Factors Affect Capital Structure Decisions

Capital structure decisions are very important for companies to make so there are certain factors which firms take in view when making capital structure decisions and they are:

  • Sales stability: A firm takes this factor under consideration at the time of capital structure decisions. If compare two firms, one having stable sales and other having unstable sales, the firm whose sales is relatively stable can safely take on more debt and incur fixed charge in comparison to the company with unstable sales. For instance, the utilities companies use more financial leverage than industrial firms because they have stable sales
  • Operating structure: This is another factor which is involved in making capital structure decisions. A firm having less operating leverage can imply financial leverage in better way as it will have less business risk.
  • Assets structure: This factor may affect the capital structure decisions; there are two types of assets-general purpose assets and special purpose assets. The real state companies usually use general purpose assets as it makes good collateral. While the companies which are involves in technological research use special purpose assets, as they are not highly leveraged.
  • Profitability: The factor of profitability also plays an important role in capital structure decisions; because the firms which get high rates of return on investment do not use high debt, but they use relatively little debt, as high rates of return on investment make them able to do financing with internally generated funds.
  • Growth rate: This factor plays an important role in capital structure decision making. It has been observed that faster growing firms mostly rely on external capital as the flotation costs exceeds those incurred when selling debt this is the reason that rapidly growing firms rely more heavily on debt. It is also possible that the firms relying on external capital may often face greater uncertainty due to which those firms reduce their willingness to use debt.
  • Control: there is great affect of control situation on capital structure decisions, because in such a situation when management has 50% voting control between the debt and equity. If the management is not in a position to buy or purchase any more stock, the other option for it is to use debt for new financing. But in the situation when the firm’s financial position is so week that the use of debt may be the cause of serious risk of default. In this situation the control considerations could lead to use either debt or equity.
  • Taxes: As far as interest is concerned it is, no doubt a deductible expense which is much valuable to firms with high tax rates. It is therefore the firms use much debt because if firm’s tax rate is higher the advantage is also greater.
  • Management attitudes: different management attitudes may bring different changes in capital structure decisions. Some managements are conservatives and others are aggressive these both managerial styles exercise accordingly to their own judgments and analytical approaches about the proper capital structure. If the management attitude is conservative it uses less debt, where is the management having aggressive approach uses more debt to get higher profits
  • Lender and rating agency attitudes: A part from manager’s analysis of the factors lenders and rating agencies also plays an important role in financial structure decisions. The corporations give much importance to the lenders and rating agencies and make discussions with them about the capital structure and mostly act accordingly to their advice.
  • Market conditions: Capital structure also depends on market conditions, a firm’s optimal capital structure or favorable capital structure depends on long-term and short-term changes. Low rated companies which are in need of capital either go for the stock market or to the short-term debt market without taking consideration of target capital structure.
  • Financial flexibility: financial flexibility has also a bearing on capital structure decision. Affirm or company makes the decision according to its financial flexibility, if a company is financially good it can raise capital with either stock or bond. But; when its financial position is week the suppliers of capital make funds available, if that company gives them a secure position in shape of debt. Seeking all above thoughts in mind it can be said that the companies should maintain the financial flexibility or adequate reserve borrowing capacity because it depends on the factors which are necessary in making capital structure decisions.
  • Firm’s internal conditions: this is also one of the factors which affect the capital structure decisions. If a firm succeeds in completing any project than the probability of higher returns increase in the near future. Due to such internal conditions a company would not issue stock because the new earnings are neither anticipated nor reflected in the stock prices. So in such condition the company or firm would give preference to finance with debt and till the higher earnings are materialized and or reflected in the stock prices.

Statement Of The Problem

Capital structure decision is very crucial and important for any organization in any sector or economy. It is always very much difficult for organizations to identify or gets the right combination of debt and equity (Capital Structure), which ultimately satisfies them or brings favorable and profitable results for the organizations.

So; eventually this report mainly focusing on right combination of “Debt and Equity (Capital Structure) in the characteristic of Short-term Debt (SDA), Long-term Debt (LDA) and Total Debt (LA)” for any organization in Pakistan. In Pakistan modest research has done on such problem.

It is important to work on such problem and come up with information, which gives some comfort level to investors and organizations to take correct financing decisions.

Objective

It is very important in Pakistani scenario to evaluate or investigate the impact or the influence of capital structure over the firm profitability. In this way the objective of this study is to investigate or evaluate the relationship among the rates of return of the listed non-financial firms on Karachi Stock Exchange (KSE-100) index related to composition of the capital structure.

More exclusively, this is based on the assertion that whether short-term debt divided by total capital (SDA), long-term debt divided by total capital (LDA), and Total debt divided by total capital (TD) has positive or negative relationship with profitability.

Research Scope/Limitations

The scope of study to analyze impact of capital structure on profitability, also promotes as an aim for future research.

Few limitations fixed up in this study:

  • This research would just cramp to secondary data.
  • The admittance would restrict to public information, all organizations would not share information that would confidential in nature.
  • This study would not get into the details concerning factors that lead to capital structure or the reasons due to which capital structure comes in different combinations.

Thesis Structure

The report is systematized as follows. Phase one (1) introduction of the thesis, which includes the statement of problem, scope and limitations objectives hypothesis etc, this phase, also contains the some of the theoretical perspective regarding the capital structure. In phase 2 we describe Methodology that is constitutes the data and we justify the choice of the variables used in our analysis sample, technique and also estimate model used in analysis. In phase 3 we presents and analysis the results which taken after the data processing. The phase 4 contains the results and conclusions and recommendations.

Literature Review

Pakistan has not yet got much development in the bond market; therefore, many firms of Pakistan give preference to equity or internal financing in comparison to debt, but one day when this negative relationship between profitability and leverage of the firm will be removed, the Pakistani firms will realize the importance of debt financing, because it is the debt financing which increases the value of the firm and the wealth of the share holders (Ilyas. 2000).

Study conducted (Rafiq, et al., 2008); it has been observed that the chemical sector of Pakistan gives preference to equity over debt and large firms borrow more debt because they have no fear of bankruptcy whereas small firms are afraid of more debt because of the fear of bankruptcy. In chemical sector huge cash flows are needed, therefore, the chemical industry of Pakistan uses more debt than equity to finance the new projects because the internal sources are not enough for a new firm, therefore, it depends on the debt because the fixed direct costs of bankruptcy constitutes a smaller portion of the total value the firm. The other reason for which most of Pakistani firms prefer to equity or internal financing over debt is that the bankruptcy process is slow an ineffective in Pakistan due to which firms face no or low bankruptcy costs.

Study conducted (Hijazi and Tariq, 2006); study reveals that as for as the firm size is concerned, the Static Tradeoff Theory suggests that if the firm size is bigger, more debt will be used, but in Pakistan, the case is in reverse, here, the firm size is negatively correlated with leverage and the bigger firm size use less debt which supports the Pecking Order Approach and rejects the Static Tradeoff approach. After the deep observation of Asset structure, it has been concluded that asset structure of Pakistani firms does not depend on their capital structure. As the large firms of Pakistan have no fear of bankruptcy and have less chances to fall into financial distress or in other words, they are strong enough to bear shocks, so they employ more debt in comparison to smaller firms which have fear of bankruptcy because large firms face lower bankruptcy costs, therefore, there is, in large firms, strong relationship between profitability and leverage. The profitability, in large Pakistani firms, supports the Pecking Order Theory which is measured by net profit before taxes divided by total assets.

Research conducted by Abor (2005) supports or investigates the relationship between the capital structure and profitability of listed firms on GSE. Data taken for this between 1998/02, twenty-five listed firms qualified for this study. Regression analysis methodology used in the assessment of functions involving the return on equity (ROE) with measure of capital structure. Capital structure is the combination of debt and equity used in the firm’s operations. Capital structure is related to the marketing, because different firms issue different securities in many different combinations, which maximize the market value. The impact of capital structure on profitability had been accounted in a considerable number of studies weather experimental or theoretical perspectives. Capital structure decision is very important for any organization to get higher return and profits and meet with the competition, different combinations of capital structure available to organizations; they select one which eventually satisfies or maximizes the firm’s market value. Huge return and profitable firms always use more short-term debt, short term is important part of total debt, and usually firms use 85% of short-term loan against long-term debt. Long-term debt and return on equity have negative relationship; total debt and return on equity are positively related.

Coleman (2007) conducted study to find out the impact of debt policy on the performance of microfinance firms. Findings of the study demonstrate positive relationship between debt and firm’s performance. Long-term debt has positive relationship with outreach but not significant where as; short-term debt exercise force on management to extend a MFI’s outreach. Long-term debt helps management through the time, so that the pressure of refund decreased which ultimately; give management flexibility to improve their profitability or returns by manipulating their operations. In microfinance organizations the leverage is positively related with outreach stage; when the leverage increase which also result in the increase of outreach level; credit advance leads to higher premium. This premium further converted into company’s profitability and income flow which can also be employed to examine the debt. Higher outreach lowers the cost of operation by enabling firms to enjoy the economies of scale. Size is insignificant variable and outreach is negatively affected by it. Long-term debt and short-term debt are insignificant basically describe that maturity may not essentially be of spirit with default charge employee as performance variable though; total debt ratio determine significant relationship between leverage and default rates. Microfinance organizations which want to improve firm’s profitability and want to retire its debt obligations management can achieve these results by reducing the annual default rates especially for largely leverage microfinance organizations. Default rate has negative relationship with the size of microfinance organizations; for the reason that firm’s make sure refund of loans advanced and also become aware for future transactions this all happens when firms expands their sizes. There is negative relationship between debt and default rate, greater mean variation result in lower default rate. Though management of the firms try to reduce default rates with the higher mean deviation found in risk level. So ultimate findings of the study reveals that microfinance institutions in Ghana finance their operations through the long-term debt as compare to short-term financing and they tend to be highly leveraged. Microfinance organizations benefit from scale of economies, additional customers when they are significantly leveraged; and also understand and increase ability to deal with risk and other alternatives easily and importantly.

Study conducted by (Chen et al., 2009) in insurance industry Taiwan, to know the relationship among capital structure, operational risk, and profitability. Factor analysis and path analysis methodologies used to examine correlation among the capital structure, operational risk, and profitability sample of listed insurance companies in America was also taken. Result of research was firms values is not related with capital structure, a close relationship shown among operational risk, profitability, capital structure. Capital structure is negatively related with profitability if equity ratio increases or reserve-to-liability ratio decreases which result in higher profits. Capital structure has negative relationship with operational risk, same relationship between the operational risk and firm’s profitability.

Research conducted by Carpentier (2006) Quebec Canada. Objective of study was to investigate the changes in capital structure do not affect the firm value. The bivariate tests and multivariate regression analysis methodologies are used for this study. Sample size of 243 French firms has taken for this study during the time period 1987-96. If all other things equal, then capital structure don’t define any changes in the value of business organizations. Investors take debt in the considerations in order to determine the stock prices. Cross-sectional relationship found between the value of firm and debt exists, many factors affect firm value in long run the debt-value relationship. The static trade-off theory posits that the firm value increase (decrease) as the financial structure moves closer to (away from) the target. French companies tend to use a higher proportion of total debt and a higher proportion of institutional debt (non spontaneous funds) than US companies.

Study was conducted by (Groth & Anderson, 1997). Study explains capital structure and investigates its influence on the cost of capital and the value of company. This study sketches practical concerning the choices and management of capital structure. A theoretical and practical understanding of these relationships will support the professional manager in his or her efforts to gather added value for shareholders and stakeholders. Firm’s value and its stock prices does not affected by capital structure, optimal way to finance the firm exists. Capital structure theory is of value even if the arrays of assumptions in the theory do not hold. If an economic variable changes for example: interest rates, recessions, and the price of bearing risk affect the management decision of capital structure. Capital structure offer prospect of enhancing value for shareholders, it also time reduction in cost of capital to the economy and the standard of living.

Research conducted by Rocca (2007) Italy, main purpose of this research to scrutinize the relationship between capital structure and firm value. Capital structure represents a corporate governance device that can protect corporate governance competence and protect its ability to create value. Methodology or approach used for this study is theoretical approach that can contribute in clearing up the relationship between capital structure and corporate governance. Descriptive, model also used which provides a research proposition and some suggestions, which would be used for future empirical research and precise design given for empirical analysis. Finding of this study is that, relation between capital structure and a firm’s value needs to take directly into account the role of moderation and/or mediation of the corporate governance. It is also necessary that presence of complimentary between capital structure and corporate governance variables such as: managerial ownership; ownership concentration; role of board of directors, etc.

Study conducted (Ebaid, 2009) study mainly focus on relationship between the different debt-equity combinations with company’s performance. Multiple regression technique used to find out the impact of debt policy on company’s performance. Enormous studies conducted on debt policy alternative on firm’s performance; among them majority of researches conducted in developed countries; just few studies performed in emerging countries or economies one of them is Egypt. The research mainly focus on the relationship between alternative debt policy with firms firm’s performance data taken from listed Egyptian companies; performance is measured through accounting-based perspective such as: Return on Assets, Gross Profit Margin, and Return on Equity generally known as (ROA, GPM, and ROE), capital structure is measured with short-term debt and long-term dent and total debt abbreviation as (STD, LTD and TTD). Findings of the study reveal that both (STD and TTD) are negatively related by ROA. Alternatively capital structure including total debt (TTD) in not significantly related with Return on Equity and Gross profit margin (ROE and ROA). Results of the study suggest that the performance of the Egyptian listed companies in not controlled (weak-to-no influence) by capital structure alternatives. Though; particularly in emerging markets debt policy remains debatable and mystery. Further research might observe determinants of Egyptian firms’ capital structure such as growth, business risk size and also evaluated with developed economies. The impact of capital structure on Egyptian firm’s value as well necessitates analyzing empirically. Findings of the study reveal that ROA and firm performance negatively related. It can also be investigated the impact of the maturity structure on its performance and capital structure decisions. Firm’s performance can jointly be by both ownership structure and capital structure in further studies in listed Egyptian firms.

Study conducted (Eriotis et al, 2007) to investigate the firm characteristics that affect debt-equity combination. Data has been taken from 129 Greek listed firms at Athens Stock Exchange five (5) years time have taken under observation from 1997-2001, it is the 63% of listed companies in 1996. Through diverse theories company’s characteristics are investigated as determinants of capital structure. The firms which employed debt ratio of 50% or more are also categorized in this research with a dummy variable. Results of the research reveal that firm’s debt ratio is negatively related with its growth rate and also its interest coverage ratio and quick r


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